1. Corporate Finance MLI28C060 Lecture 12 Tuesday 27 October 2015

2. Working capital management Structure: - Definition of working capital management (WCM) - Introduction of principal financial instruments used in WCM - Implications of effective WCM for MNE firms Reading: Stonehill & Eiteman: Chapter 21

3. Lecture Structure Alternative current operating assets investment and financing policies Cash, inventory, and A/R management Accounts payable management Short-term financing Bank loans, their costs, and commercial paper

4. Value = + + ··· + FCF 1 FCF 2 FCF ∞ (1 + WACC) 1 (1 + WACC) ∞ (1 + WACC) 2 Free cash flow (FCF) Market interest rates Firm’s business riskMarket risk aversion Firm’s debt/equity mix Cost of debt Cost of equity Weighted average cost of capital (WACC) Sales revenues Operating costs and taxes Required investments in operating capital − − = Determinants of Intrinsic Value: Working Capital and FCF

5. Working capital management in a multinational enterprise requires managing current assets (cash balances, accounts receivable and inventory) and current liabilities (accounts payable and short-term debt) when faced with political, foreign exchange, tax and liquidity constraints. The overall goal is to reduce funds tied up in working capital while simultaneously providing sufficient funding and liquidity for the conduct of global business. Working capital management should enhance return on assets and return on equity and should also improve efficiency ratios and other performance measures. Working Capital Management

6. Working Capital Current assets – Current liabilities It measures how much in liquid assets a company has available to build its business. A short term loan which provides money to buy earning assets. Allows to avail of unexpected opportunities. Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable and cash. An increase in working capital indicates that the business has either increased current assets (that is received cash, or other current assets) or has decreased current liabilities, for example has paid off some short-term creditors.

7. Working Capital Management Decisions relating to working capital and short term financing are referred to as working capital management. Short term financial management concerned with decisions regarding to CA and CL. Management of Working capital refers to management of CA as well as CL. If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit. These involve managing the relationship between a firm's short- term assets and its short-term liabilities.

8. Working Capital Management The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses. Businesses face ever increasing pressure on costs and financing requirements as a result of intensified competition on globalised markets. When trying to attain greater efficiency, it is important not to focus exclusively on income and expense items, but to also take into account the capital structure, whose improvement can free up valuable financial resources

9. WORKING CAPITAL MANAGEMENT Active working capital management is an extremely effective way to increase enterprise value. Optimizing working capital results in a rapid release of liquid resources and contributes to an improvement in free cash flow and to a permanent reduction in inventory and capital costs, thereby increasing liquidity for strategic investment and debt reduction. Process optimization then helps increase profitability.

10. WORKING CAPITAL MANAGEMENT The fundamental principles of working capital management are reducing the capital employed and improving efficiency in the areas of receivables, inventories, and payables.

11. Why working Capital is important? Investment in Current Assets (CA) represents a substantial portion of total investment. Investment in Current Assets (CA) and level of Current Liabilities (CL) have to be geared quickly to changes in sales.

12. Gross Working Capital Total Current assets Where Current assets are the assets that can be converted into cash within an accounting year & include cash, debtors etc. Referred as “Economics Concept” since assets are employed to derive a rate of return.

13. Net Working Capital CA – CL Referred as ‘point of view of an Accountant’. It indicates liquidity position of a firm & suggests the extent to which working capital needs may be financed by permanent sources of funds.

14. CONSTITUENTS OF WORKING CAPITAL CURRENT ASSETS  Inventory  Sundry Debtors  Cash and Bank Balances  Loans and advances CURRENT LIABILITIES  Sundry creditors  Short term loans  Provisions

15. Characteristics of Current Assets Short Life Span I.e. cash balances may be held idle for a week or two, thus a/c may have a life span of 30-60 days etc. Swift Transformation into other Asset forms I.e.each CA is swiftly transformed into other asset forms like cash is used for acquiring raw materials, raw materials are transformed into finished goods and these sold on credit are convertible into A/R & finlly into cash.

16. Matching Principle If a firm finances a long term asset(like machinery) with a S-T Debt then it will have to be periodically finance the asset which will be risky as well as inconvenient. i.e. maturity of sources of financing should be properly matched with maturity of assets being financed. Thus Fixed Assets & permanent CA should be supported with L-T sources of finance & fluctuating CA by S-T sources.

17. MATCHING PRINCIPLE

18. Need for Working Capital As profits earned depend upon magnitude of sales and they donot convert into cash instantly, thus there is a need for working capital in the form of CA so as to deal with the problem arising from lack of immediate realisation of cash against goods sold. This is referred to as “Operating or Cash Cycle”. It is defined as “The continuing flow from cash to suppliers, to inventory, to accounts receivable & back into cash “.

19. Need for Working Capital Thus needs for working capital arises from cash or operating cycle of a firm. Which refers to length of time required to complete the sequence of events. Thus operating cycle creates the need for working capital & its length in terms of time span required to complete the cycle is the major determinant of the firm’s working capital needs.

20. Basic Definitions Working capital: Total current assets used in operations. Net working capital: Current assets – Current liabilities. Net operating working capital (NOWC): Operating CA – Operating CL = (Cash + Inv. + A/R) – (Accruals + A/P) 20 (More…)

21. Working Capital Working Capital – All the items in the short term part of the balance sheet e.g. cash, short term debt, investments, inventory, debtors (receivables), payables (creditors) etc Net Working Capital is the difference between Current Assets and Current Liabilities Cash Management, Liquidity Management Interconnected terms. 21

22. Definitions (Continued) Working capital management: Includes both establishing working capital policy and then the day-to-day control of cash, inventories, receivables, accruals, and accounts payable. Working capital policy: – The level of each current asset. – How current assets are financed. 22

23. Cash Conversion Cycle (simple operational cycle) Cash Raw Materials Inventory Finished Goods Inventory Receivables

24. CCC model 1 Cash conversion cycle = operating cycle – accounts payable period = (inventory period + receivables period) – accounts payable period Average inventory period = average inventory / daily cost of goods sold Average Receivables Period = average accounts receivable / sales Average payables period = average accounts payable / daily cost of goods sold

25. Example question – for class Income Statement SalesUSD 20,500,600 Cost of Goods SoldUSD 15,200,100 Balance Sheet InventoryUSD 2,000,500 Accounts ReceivableUSD 1,500,800 Accounts PayableUSD 1,200,000 Table: Annual Balance sheet Question. What is the cash conversion cycle for above firm? [Hint: calculate the “Average inventory period”, then the “Average receivables Period”, then the “Average Payables Period” before finally attempting the CCC]

26. CCC (Cash Conversion Cycle) Model 2 26 The cash conversion cycle focuses on the time between payments made for materials and labor and payments received from sales: Cash Conversion = Cycle Inventory Conversion + Period Average Collection − Period Payables Deferral Period

27. Selected Ratios for SKI 27 SKIIndustry Total Liabilities/Assets58.76%50.00% Turnover of Cash16.6722.22 DSO(365-day year) (Days Sales Outstanding) 45.6332.00 Inventory Turnover6.008.00 Fixed Asset (FA) Turnover7.7513.22 Total Asset (TA) Turnover2.083.00 Profit Margin2.07%3.50% ROE10.45%21.00% Payables deferral30.0033.00

28. Cash Conversion Cycle (Cont.) Data: – Annual sales = $660,000 – Cost of Goods Sold (COGS)/Sales = 90% – Inventory turnover = Sales/Inventory = 6. Inventory = ?? COGS = ?? Inventory Conversion = ?? = ?? days. 28

29. Cash Conversion Cycle (Cont.) Data: – Annual sales = $660,000 – Cost of Goods Sold (COGS)/Sales = 90% – Inventory turnover = Sales/Inventory = 6. Inventory = $660,000/6 = $110,000. COGS = (0.9)($660,000) = $594,000. Inv. Conv. = $110,000/($594,000/365) = 67.6 days. 29

30. Cash Conversion Cycle (Cont.) 30 CCC = + – CCC = 67.6 + 45.6 – 30 CCC = 83.2 days. Inventory conversion period Payables deferral period Days sales outstanding

31. Cash Management: Cash doesn’t earn interest, so why hold it? Transactions (Routine): Must have some cash to pay current bills. Transactions (Precaution): “Safety stock.” But lessened by credit line and marketable securities. Compensating balances: For loans and/or services provided. Essential that the firm have sufficient cash to take trade discounts. 31

32. What’s the goal of cash management? Minimize the cash amount the firm must hold for conducting its normal business activities, yet, at the same time, have a sufficient cash reserve to: take trade discounts. pay promptly and maintain its credit rating. meet any unexpected cash needs. 32

33. Ways to Minimize Cash Holdings Use lockboxes. Insist on wire transfers or automatic debit from customers. Synchronize inflows and outflows. Use float. 33 (More…)

34. Minimizing Cash (Continued) Increase forecast accuracy to reduce the need for a cash “safety stock.” Hold marketable securities instead of a cash “safety stock.” Negotiate a line of credit (also reduces need for a “safety stock”). 34

35. Cash Budget: The Primary Cash Management Tool Purpose: Uses forecasts of cash inflows, outflows, and ending cash balances to predict loan needs and funds available for temporary investment. Timing: Daily, weekly, or monthly, depending upon budget’s purpose. Monthly for annual planning, daily for actual cash management. 35

36. Data Required for Cash Budget Sales forecast. Information on collections delay. Forecast of purchases and payment terms. Forecast of cash expenses: wages, taxes, utilities, and so on. Initial cash on hand. Target cash balance. 36

37. SKI’s Cash Budget for January and February Net Cash Inflows JanuaryFebruary Collections$67,651.95$62,755.40 Purchases44,603.7536,472.65 Wages6,690.565,470.90 Rent2,500.00 Total Payments$53,794.31$44,443.55 37

38. Cash Budget (Continued) JanuaryFebruary Cash on hand at start of forecast $3,000.00 Net CF (Collection – Payment) 13,857.6418,311.85 Cumulative NCF$16,857.64$35,169.49 – T arget cash 1,500.00 Surplus cash$15,357.64$33,669.49 38

39. Should depreciation be explicitly included in the cash budget? No. Depreciation is a noncash charge. Only cash payments and receipts appear on cash budget. However, depreciation does affect taxes, which do appear in the cash budget. 39

40. What are some other potential cash inflows besides collections? Proceeds from fixed asset sales. Proceeds from stock and bond sales. Interest earned. Court settlements. 40

41. How can interest earned or paid on short-term securities or loans be incorporated in the cash budget? Interest earned: Add line in the collections section. Interest paid: Add line in the payments section. Found as interest rate x surplus/loan line of cash budget for preceding month. Note: Interest on any other debt would need to be incorporated as well. 41

42. How could bad debts be worked into the cash budget? Collections would be reduced by the amount of bad debt losses. For example, if the firm had 3% bad debt losses, collections would total only 97% of sales. Lower collections would lead to lower surpluses and higher borrowing requirements. 42

43. Cash budget forecasts the company’s cash holdings to exceed targeted cash balance every month, except for October and November. Cash budget indicates the company probably is holding too much cash. SKI could improve its EVA by either investing its excess cash in more productive assets or by paying it out to the firm’s shareholders. 43

44. Why might SKI want to maintain a relatively high amount of cash? If sales turn out to be considerably less than expected, SKI could face a cash shortfall. A company may choose to hold large amounts of cash if it does not have much faith in its sales forecast, or if it is very conservative. The cash may be there, in part, to fund a planned fixed asset acquisition. 44

45. Is SKI holding too much inventory? SKI’s inventory turnover (6.00) is considerably lower than the industry average (8.00). The firm is carrying a lot of inventory per dollar of sales. By holding excessive inventory, the firm is increasing its operating costs. Moreover, the excess inventory must be financed, so EVA is further lowered. 45

46. If SKI reduces its inventory, without adversely affecting sales, what effect will this have on its cash position? Short run: Cash will increase as inventory purchases decline. Long run: Company is likely to then take steps to reduce its cash holdings. 46

47. Accounts Receivable Management: Do SKI’s customers pay more or less promptly than those of its competitors? SKI’s days’ sales outstanding (DSO) of 45.6 days is well above the industry average (32 days). SKI’s customers are paying less promptly. SKI should consider tightening its credit policy to reduce its DSO. 47

48. Elements of Credit Policy Cash Discounts: Lowers price. Attracts new customers and reduces DSO. Credit Period: How long to pay? Shorter period reduces DSO and average A/R, but it may discourage sales. 48 (More…)

49. Credit Policy (Continued) Credit Standards: Tighter standards reduce bad debt losses, but may reduce sales. Fewer bad debts reduces DSO. Collection Policy: Tougher policy will reduce DSO, but may damage customer relationships. 49 Does SKI face any risk if it tightens its credit policy? YES! A tighter credit policy may discourage sales. Some customers may choose to go elsewhere if they are pressured to pay their bills sooner.

50. If SKI succeeds in reducing DSO without adversely affecting sales, what effect would this have on its cash position? Short run: If customers pay sooner, this increases cash holdings. Long run: Over time, the company would hopefully invest the cash in more productive assets, or pay it out to shareholders. 50

51. What is trade credit? Trade credit is credit furnished by a firm’s suppliers. Trade credit is often the largest source of short-term credit, especially for small firms. Spontaneous, easy to get, but cost can be high. 51

52. Current Operating Assets Financing Policies Moderate: Match the maturity of the assets with the maturity of the financing. Aggressive: Use short-term financing to finance permanent assets. Conservative: Use permanent capital for permanent assets and temporary assets. 52

53. Moderate Financing Policy 53 Years $ Perm NOWC Fixed Assets Temp. NOWC Lower dashed line, more aggressive. } S-T Loans L-T Fin: Stock & Bonds,

54. Conservative Financing Policy 54 Fixed Assets Years $ Perm NOWC L-T Fin: Stock & Bonds Marketable Securities Zero S-T debt

55. What are the advantages of short-term debt vs. long-term debt? Low cost-- yield curve usually slopes upward. Can get funds relatively quickly. Can repay without penalty. 55

56. What are the disadvantages of short-term debt vs. long-term debt? Higher risk. The required repayment comes quicker, and the company may have trouble rolling over loans. 56

57. Commercial Paper (CP) Short term notes issued by large, strong companies. SKI couldn’t issue CP--it’s too small. CP trades in the market at rates just above T- bill rate. CP is bought with surplus cash by banks and other companies, then held as a marketable security for liquidity purposes. 57